Stakes High as Judge Weighs Stockton, Calif., Bankruptcy

For the people of Stockton, a federal judge's anticipated decision Monday on the California city's bankruptcy petition will affect their day-to-day lives for decades to come.

But the Chapter 9 bankruptcy case also is being closely watched nationally for the potential precedent-setting implications: whether federal bankruptcy law trumps the California law that says debts to the state pension fund must be honored.

After a three-day trial last week, U.S. Bankruptcy Judge Christopher Klein is to decide whether Stockton becomes the most populous city in the nation to enter bankruptcy, despite the objection of creditors who argued the city failed to pursue all other avenues for straightening out its financial affairs.

If it receives bankruptcy protection, the city begins a months-long process of negotiations over debt repayment that some say could end up in the U.S. Supreme Court.

"This case is worthy because of the conflict between the U.S. Bankruptcy Code and the state statutes governing CalPERS and the importance of the issue being decided," said attorney Karol Denniston, a municipal restructuring expert who monitored the trial. (Read More: Pension Funds Wary as Bankrupt Stockton Goes to Trial)

The $900 million Stockton owes to the California Public Employees' Retirement System to cover pension promises is its biggest debt as is the case with many struggling cities across California. So far Stockton has kept up with pension payments while it has reneged on other debts, maintaining that it needs a strong pension plan to retain its pared-down workforce.

The creditors who challenged Stockton's bankruptcy petition are the bond insurers who guaranteed $165 million in loans the city secured in 2007 to pay its contributions to CalPERS. That debt got out of hand as property tax values plummeted during the recession, and money to pay the pension obligation fell short.

Attorneys for the creditors argued that it was unfair for them to be paid 17 cents on the dollar for the loans while the retirement fund negotiated in flush times remains untouched. Legal observers expect the creditors aggressively to challenge Stockton's repayment plan in the next phase of the process.

"That's where it will be precedent-setting. Does bankruptcy code apply to CalPERS or not? If bankruptcy code trumps state law, then that's huge and it has huge implications in terms of what happens next for other municipalities across California," said Denniston.

The city of nearly 300,000 has become emblematic of both government excess and of the financial calamity that resulted when the nation's housing bubble burst. Its salaries, benefits and borrowing were based on anticipated long-term developer fees and increasing property tax revenue. But those were lost in a flurry of foreclosures beginning in the mid-2000s and a loss of 70 percent of the city's tax base.

By 2009 Stockton had accumulated nearly $1 billion in debt on civic improvements, money owed to pay pension contributions and the most generous health care benefit in the state coverage for life for all retirees plus a dependent, no matter how long they had worked for the city.

Since cities can't be liquidated, Stockton has attempted to restructure some debt by renegotiating labor contracts and cutting the health benefit for retirees, but creditors argued that by ignoring bond debt they haven't created a plan that shares the pain equitably, as required under bankruptcy code.

Attorney Guy Neal, who represents creditors, spent a good deal of his trial time showing that for years Stockton had granted bloated labor contracts and benefits, and then allowed employees to boost their retirement benefits further by cashing out vacation time and sick leave in their last year of employment, thus raising their benchmark annual salary for retirement benefit purposes.

He argued that employees who shared in the wealth during good times should have to equally share the pain now, including cuts to CalPERS.

"The city simply wants to wipe out its debt but hold onto the benefits that the proceeds of that debt provided," Neal argued.

Stockton's City Manager Bob Deis testified that CalPERS is a trustee for city employees, not a creditor.

The judge indicated at several points during the trial that the CalPERS attorney monitoring the case would have his time to speak during the repayment phase of the trial, an indication that the pension obligation could be a part of discussions.

"I know that issue is downstream, if we wind up going downstream," Klein said during closing arguments.

The state pension plan manages $255 billion in assets today but was underfunded by $87 billion in 2011, the last time calculations were made. CalPERS is in the process of setting new rates to close the liability, said spokeswoman Amy Norris, which could further strain cities in financial peril such as San Bernardino, San Jose Compton, Fairfield, Watsonville, Atwater and at least two dozen other cities.

"Just about everybody has an unfunded liability," said Norris.

Attorneys watching the case expect that this first-ever Chapter 9 bankruptcy case questioning state pension obligations will be appealed to decide whether the 10th Amendment giving rights to states is more powerful than federal bankruptcy code. Even Klein, who was inclined at first to approve bankruptcy without a trial, said he was going forward with the hearing to create an appellate record.

"You might have the court not approve the plan because the bondholders keep raising objections until CalPERS is impaired in some way. That will be cutting edge. That's where this case will get interesting," said bankruptcy attorney Michael Sweet.